This should be a wake up call. Financial authorities must properly implement and reinforce international prudential and resolution rules for banks.
After three bank failures in a single week and despite super-sized emergency support by global central banks, trust in banks is vanishing once again throughout financial markets. Why is this happening now, and how is this even possible, when so much has been done to strengthen banks after the 2008 crisis?
No more trust, no more bank
By design, banks are not in a position to immediately pay back all of their customers’ deposits at once. The minute customers lose confidence in the safety of their deposits, the stampede starts and banks collapse. This is exactly what we saw in the past few days.
Silicon Valley Bank’s customers queued up to get their deposits back while the daily deposit outflows of troubled Credit Suisse topped CHF 10 billion. Two otherwise incomparable scenarios happening days apart. There is one common denominator among banks such as Silicon Valley Bank and Credit Suisse: Where there is no more trust, regardless of the reason, there is no more bank.
From a systemic standpoint, the essential question is not why Silicon Valley Bank was foolish enough not to hedge the interest rate risk on its portfolio of bonds deemed “available for sale” (hedging costs money, of course); nor is the question why Credit Suisse has been jumping from one crisis to the other for several years (greed and lack of adequate governance, of course).
We must ask ourselves, instead, why and how the failure of three banks – representing less than 0.5% of the world’s banking assets (if we include Signature Bank) – is capable of threatening the entire system.
Post-2008 rules not properly implemented
Does the fact that all banks are now under pressure indicate that participants in financial markets, who are well-informed and knowledgeable about the banking system, do not trust that prudential rules are sufficient to ensure systemic stability?
The short answer is yes. Investors do not believe that the prevailing rules are sufficient to stabilise the system, and here are two main reasons for this.
- The US and EU have adopted substantial exemptions to the internationally-agreed Basel III frameworkTo learn more about the prudential rules in banking - the Basel Framework - and its implementation in the EU, read our guide: “Basel 3 in 5 questions”:
– In the US, Basel III does not apply to small and medium size banks in the US. An Act passed in 2018 raising banks’ prudential threshold from $ 50 billion to $ 250 billion.
– In the EU, by being on the verge of adopting a banking package that will apply to both large and small EU banks, capital requirements are significantly lower than those considered in Basel III.
- The Basel III framework, even if it were properly implemented, is not so demanding in the first place.
Basel III may have multiplied banks’ total capital three or four times over, and banking institutions may have improved their liquidity ratios, but we were starting from such a ridiculously low base under Basel II (on a non-risk weighted basis, banks’ capital requirements were often under 1% under Basel II) that those requirements remain modest and do little to protect banking institutions from all possible events.
This weakness is reinforced by the fact that Basel III looks at banks as separate entities but never in relation to one another: this is a huge flaw given the high interconnectedness of the banking system.
Is there no bank “small enough to fail?”
Faced with declining stock prices, CEOs of systemic banks are complaining that the market does not understand how resilient their institutions have become thanks to the prudential rules applying to them now.
The reality is that financial market participants understand very well what the rules in place mean. By voting with their feet, market participants send the message that they do not trust that the existing rules alone make for a resilient banking system.
They also know that public authorities will have to intervene each time the situation becomes difficult. If it had not been for the trillions injected by central banks in March 2020 when the pandemic forced everyone into lockdown, the financial system would have collapsed.
The deal negotiated over the weekend by Swiss authorities for UBS to acquire Credit Suisse, on terms never before seen, shows not only how bad the situation is, but also how insufficient existing rules are when things go sour. When prudential regulation fails, the last line of defense to protect society from the consequences of failing banks is resolutionResolution means the restructuring of a bank by public authority (resolution authority) when a bank is failing or likely to fail and there is no other private solution that can restore the bank to viability within a short timeframe, whereas normal insolvency proceedings would cause financial instability. Thanks to the statutory powers of a resolution authority (‘resolution tools’) – such as exercising the power to sell or merge the business with another bank, to set up a temporary bridge bank to operate critical functions, to separate good assets from bad ones and to convert to shares or write down the liabilities of failing banks – the continuity of banks’ critical functions is guaranteed and financial stability is preserved. The framework for the recovery and resolution of credit institutions in the EU comprises the BRRD and SRM. The BRRD constitutes a single rulebook for the resolution of banks (and large investment firms) in all EU Member States. It introduces harmonized tools for dealing with bank crises both to prevent failure and to restructure banks if they do face failure. The Single Resolution Mechanism implements the BRRD in the Eurozone and any other Member State participating in Single Supervisory Mechanism. Watch our dedicated webinar to learn more.
Unfortunately, despite the resolution frameworks in place, we live in a world where there is no longer any such thing as a bank small enough to fail without being bailed-out.
Since 2016, Banca Popolare di Vicenza, Veneto Banca, Banca Carige, Monte dei Paschi di Siena and NordLB have all been saved with EU public money.
Last week, US authorities did effectively the same thing by guaranteeing the uninsured deposits of Silicon Valley Bank and Signature Bank. “Good news, the rules have changed in your favor!”
In the US, like in the EU, even small banks have become “too big to fail,” or perhaps “too politically connected to fail”. The details of each situation are different but the principle is the same: public money goes into bailing-out non-systemic banking institutions or their private creditors.
Despite all the official rhetoric and legislation adopted since 2008, moral hazard remains the dominant principle in banking. The upside goes into private pockets and the downside is covered by public budgets and central banks -by society, in other words.
Don’t blame the firefighters, blame a lack of fire-proofing
This week, Members of the European Parliament, seeking reassurance that the situation is under control, have grilledRead here and here European banking supervisors. When it comes to financial stability, banking supervisors and central bankers are the firefighters, whilst legislators are the architects in charge of building a house following proper fire safety standards.
It feels somewhat ironic that EU banking supervisors should be grilled by MEPs:
The most senior representatives of EU supervisors – Luis de Guindos, Vice-President of the ECB, Andrea Enria, Chair of the Supervisory Board of the ECB and José Manuel Campa, Chair of the European Banking Authority – all warned the EU co-legislators as recently as last November about the dangers of diluting the Basel III rules. The ECON Committee of the European Parliament blatantly ignored this warning and diluted Basel III when it voted on the EU banking package on 24 January.
Perhaps supervisors should grill the co-legislators instead. Or the co-legislators should be held accountable by European citizens for giving in to the siren calls of the banking lobby against the advice of their own supervisors.
When the house is on fire, the first priority is to put out that fire. We can rest assured that central bankers will do whatever it takes to prevent the banking system from collapsing and it is the right thing for them to do. The cost to society, however, will be enormous. Citizens are left footing the bill once again, as the banking system – sure to catch fire again soon if the rules go unenforced – still cannot distinguish between banks that serve society and those banks that are fire hazards.
This is no longer acceptable.
Financial authorities need to reinforce internationally agreed prudential and resolution rules and stick to them.
Thierry Philipponnat, Chief Economist, Finance Watch